Address by Director Credit Institutions & Insurance Supervision Fiona Muldoon to the University of Limerick

19 September 2013 Speech

Financial Sector Reform – A regulatory perspective

Thank you for the invitation to speak to you today. It is my pleasure to be here in the University of Limerick, to speak to you about the topic of Financial Sector reform.

Given the very broad scope of the topic, I have decided to focus on the European regulatory integration perspective and in particular on two components – progress towards Banking Union and, to a lesser extent, Solvency II. These two elements serve to effectively demonstrate both what the EU can achieve and to highlight the very real difficulties that sometimes emerge in trying to agree anything among 27, indeed now 28, separate member States.

In the context of financial services and banking in particular, the European legislative agenda has changed significantly over the last few years, one of the many consequences of “living in interesting times”. Supervisory authorities and the banking industry were adjusting to a Basel II/CRDIII world when the financial crisis hit in 2007. This led, among many other things, to a fundamental rethink by the Basel Committee and gave us Basel III with its greater emphasis on quality of capital, liquidity regulation, counter cyclical buffers and regulation of systemically important financial institutions. The European Commission moved to develop this into proposals for CRDIV and, thereafter in delivering on other G20 commitments, proposals for Bank Resolution and Recovery. Fast forward, five years however, and by June 2012, as the EU went from market-led crisis to crisis, EU leaders recognised that more was needed to break the link between sovereign risk and banking risk in the Euro area. A major step forward was taken in June 2012 with the decision to agree a Single Supervisory Mechanism (SSM) and the speed with which Europe’s co-legislators subsequently reached unanimous agreement on the legislative text for this was impressive by any measure but definitely more so in an EU context. That experience also underscores the fundamental and obvious reality of the regulatory experience at the EU; namely where there is a political will there is almost always a way. The Commission published proposals in October 2012 and agreement was reached with Council and Parliament in April 2013 – all in all, an example of what can be done and a very different scenario to the drawn out process of Solvency II negotiations (to which I will return later).

The term “Banking Union” has since of course, become synonymous with SSM. Technically, however, Banking Union is wider, encompassing also CRDIV, revised responsibilities for the European Banking Authority, and new rules for both resolution and deposit guarantee which open up the possibility at least, of some form of European funding for bank resolution. Indeed, the Commission Communication of September 2012 was clear in its call not only for a single banking authority but also a single resolution mechanism together with a single deposit guarantee scheme. I want to give a short Central Bank of Ireland perspective on this wider principle of Banking Union.

Firstly, we have an overarching approach to Banking Union that recognises the need for such Union as a good thing! In addition to strengthening regulation and banking supervision and breaking, or as Oli Rehn has recently said “diluting”, the link between states and the banks, it may move us to a deeper (albeit smaller) single market. As a result we remain strongly motivated to be constructive in furthering this agenda. We view, in this case, compromise, negotiation and the balancing of competing interests as a furtherance of the overarching strategic objective of a successful single regulatory and supervisory regime within the wider objective of true European economic and monetary union. In turn this can help break the damaging link between the sovereign and the banks, thus protecting the Eurozone. While proposals on bank resolution and deposit guarantee remain to be finalised, and the possibility of a common resolution authority and a common deposit guarantee scheme remains some way off, CRDIV and SSM have been agreed and we are working with the ECB and colleagues in the EBA to ensure that they are implemented and delivered upon.

As I have said the speed with which agreement was reached on SSM was impressive, however it is also important to understand how difficult these negotiations were. These particular negotiations required unanimity and were further complicated as we were working within existing EU Treaty structures which restrict the room for manoeuvre in certain areas. The declaration agreed at the Informal Ecofin held in Dublin last April recognises the potential constraint that some view the Treaty structures may impose on the ultimate model for Banking Union. A critical factor with SSM and an impetus for the aforementioned political will that created the compromise, innovation and ultimate agreement, was the potential consequences of failing to do so and the message that would send to the markets regarding Europe’s ability to “get its house in order”.

The agreement on SSM broadly delivers on what the Central Bank, among others, wanted:

  • The ECB is ultimately responsible for the direct supervision of all significant banks in all SSM participating States, with practical on-going supervision and decision making modalities set in a framework agreed by the ECB.
  • The ECB has the facility to intervene and take over direct supervision of particular less significant credit institutions if it believes this is warranted (e.g. a national supervisor is failing to appropriately deal with risks in a particular institution or to appropriately perform its functions with respect to its banking industry). Otherwise, there would remain a risk or perception of a risk that some form of two tier system was in place thus undermining the Single Market (e.g. signaling that some banks are riskier, disrupting cash flows).
  • We believe that with approximately 6000 banks to supervise, the extent of direct centralised ECB supervision and decision making necessarily differs across different categories of banks based on such factors as balance sheet size, systemic importance and cross border activity.
  • SSM will be operational next year, most likely in the last quarter.

All of that speaks to the role of Supervisor. The role of policy maker or regulator will continue to fall to the European Banking Authority. Why? Because in moving the euro area to a deeper integration, we risked leaving behind the achievement of the European project over the last 50 years in developing significant European Union integration. Further, and perhaps worse still, we risked leaving outside entirely, significant large Member States who choose not to participate. So the agreed compromise prevented a clear break within the European Union - banking supervision within the Euro-zone is assigned to the ECB but regulation remains at a pan European level with the EBA. This in turn, of course, raised the issue of voting rights at the EBA table which was a matter of significant concern for the “outs” generally and for the UK in particular. Ultimately, a double majority system was agreed (a majority of states participating in SSM and separately a majority of those not participating is required) for decisions adopted by qualified majority. This recognises the concerns of those Member States outside the Euro area (who chose not to “opt-in” around the level of influence that ECB/SSM caucus could otherwise bring to bear on the EBA’s work particularly in the context of preparing Technical Standards.

But what about the broad, practical and strategic impacts of these changes? The starting point here in Ireland, as we all now know, is a strong desire to break or dilute the destructive merry-go-round that has become; weak bank leads… bail out by sovereign…..leads to stressed sovereign finances and weak economic conditions and… even weaker banking systems. Or, as we have seen in certain other cases; weak sovereign leads to funding difficulties for banks leads to stressed banks and on we go. So, Europe has taken the first very important steps to establish SSM. Other equally important steps on the agenda remain and must follow: including not least, the quality of such supervision. Firstly though, we must establish operational parameters for the use of the European Stability Mechanism (ESM) for direct recapitalisation and we need an agreed framework and set of national powers for resolution if we are to make banking union a success and ultimately if Europe is to resolve the financial crisis. The Central Bank argues that these are needed in tandem to preparing for the operation of the SSM. In order to ensure reform is complete, agreement on a European-level resolution authority must follow shortly and then finally European deposit guarantee arrangements will be explored at a later stage. Without all three, the project cannot be considered complete.

And what of the SSM from a practical supervisory perspective? To my mind, banking union holds out the prize of meaningfully strengthening the framework for European banking supervision, if implemented successfully. If done correctly it can create some institutional distance between supervisors, the banks they regulate and the political systems within which those same banks operate. Strengthening and institutionalising this independent distance can help improve the capacity for challenge and ensure a broader, more detached, perspective on problems. I missed the Celtic bubble having been abroad from 2003 to 2010 and, I can tell you, sometimes distance does indeed lend perspective. From another much smaller island in the Atlantic, our growing property bubble was reasonably obvious and frequently commented on to me by non-Irish colleagues. The aftermath, the slow motion crash of the economy from that point up to the October 2010 bailout may also have been sharper for being seen from a distance. However bringing an outsider’s perspective is not, nor will it ever be, sufficient in and of itself to fix the woes of our current banking system. It is even arguable whether regulation can ever fix or is the proper tool to try and fix it once so badly broken. From my perspective now, in my current role, it would seem that the recovery piece for Irish banking, in particular, requires an active intervention and a forcing of the pace that at this point requires not a distance (as is normally an advantage in prudential supervision) but a closeness to the particular commercial realities and the cultural sensitivities of Irish society. This is probably as true here as it for the other countries facing acute difficulties, Spain, Greece, Portugal et al. It also means that it will be fascinating to watch the development of the Recovery and Resolution framework in tandem with the SSM. The question of who will supervise has been answered. The questions of who will pay and who will clean up in the event of future failure are every bit as critical and for now at least remain.

It is my view that it is the job of regulation and of supervision to prevent these problems in the first instance and it is here that the failure of regulation globally and more particularly in Ireland, is most apparent. The job of regulation is not necessarily to prevent failure (it is healthy after all, in a capitalist system, for weak businesses to fail and strong ones to survive and prosper); it is however regulation’s task to ensure that the impact of such failure is contained and limited. That this did not happen in our case (or elsewhere in Europe) is obvious. So, what SSM holds open is the prospect of an institutional framework, a broader skill set and more diversity of experience that should help insulate supervisors from the pressures that inevitably arise in any human interactions - those subtle and more direct, the cultural and the political - that naturally arise from close proximity to the industry it regulates, its champions and its advocates. More broadly and for the next time, SSM also has the potential to introduce a healthy distance between the necessary and worthwhile drive for local economic growth (usually brought about by a healthy bank industry borrowing and lending) and the resultant inherent risk of over-heating those same economies. This can be done through the SSM availing of its future powers to use macro-economic instruments (as Stefan has alluded to) - industry-wide rules governing for example the imposition of loan-to-value ratios, loan–to-income ratios and so forth.

Of course coming with challenge and outsiders’ perspective will also require a new culture or way of doing our business. This can only strengthen supervision in a small country such as ours where consensus, compromise and political nous, all of which are valuable in and of themselves but are sometimes valued at the expense of independent thought, accountability and the ability to deliver. The diversity of opinion and outlook, the diversity of skills and complimentary abilities, the different experiences of outsiders are amongst those things that were most lacking in the corporate governance of our banks in the past and in the approach of the regulator leading up to the crisis. Reform begins when we allow such challenge to our accepted thought process and way of doing things. Such challenge to the status quo is rarely comfortable and appears to be particularly culturally difficult for us here in Ireland.

Once in place, there will be in addition, not a few practical implementation challenges in a task of this size. I will briefly mention three of them.

First, the fact that there must necessarily and correctly be a division of labour between national supervisory authorities and central SSM staff at the ECB. This raises practical, perhaps seemingly mundane matters of organisation, decision making and cost. I believe however there will be profound consequences. The SSM will have a carefully calibrated governance structure, involving a Supervisory Board that interacts with the ECB Governing Council. At the bottom of a complex and probably hierarchical system (given the way of these things) will be the various national supervisory frontline staff each making judgments daily and reporting on hundreds of issues, actions and decisions with this volume surging in times of stress. It is likely that the volume of these decisions is considerably greater in supervision than it is in monetary policy (the ECB’s existing domain). It will therefore be critical that accountability, responsibility and ownership are clearly delineated from the start. It is also obvious that unless this is done in an efficient, balanced way there is a risk of significant duplication of effort, delay in decision making, and/or additional cost from the new system which could add further to the not insignificant current compliance cost on regulated businesses (in turn passed to the customer) and lengthen the turnaround for decision making.

Second, it is important that supervisory practices and procedures converge as quickly as practicable into a common approach. Such integration will not be easy and is likely to take some time. My own experience, in the two years since joining the Central Bank, of trying to change such practices is a case in point. In my experience in both the private and public sector, the structural constraints are significantly more challenging in the public sector and, it takes considerable time, energy and collective organizational effort to implement such changes and processes and more time again to ensure that they have taken hold amongst all of the many folk working on such matters all through the process chain. In the case of the SSM, we will have at least 18 supervisors from different cultures to meld together. Developing a common framework for risk assessment, with a common language for risk and common approaches to inspection and supervisory reviews, will be a process that forges this integration out of necessity and will involve some crucial early practical design questions.

Third, and closely related to this last point, it will be important to develop a common supervisory philosophy and risk appetite. Will the SSM under the ECB be a principles based supervisor, a rules-based one or some judicious mix of the two? Will staff be encouraged to challenge within the organization and the firms they supervise or not? It is important to articulate the essential elements of the supervisory approach so that front line colleagues - and the banks they supervise - have a clear understanding of the rules of engagement. I very much hope to see SSM given a clear mandate to speak freely, to be challenging and assertive but courteous and realistic with banks and with the centre /senior management in order to ensure that key risks are not just identified but are definitively mitigated in a time-bound manner. This ability both to challenge the firms and to challenge the internal hierarchy will require a cultural shift in many regulatory jurisdictions. We have started such change locally ourselves with the Central Bank’s risk-based supervision framework - PRISM - but consistency, consolidation and implementation work remain. The nature of most public sector organisations means that the road is not yet fully travelled and the potential risks of reversion or obfuscation mean that committed vigilance and resolve must remain to the fore in the mind of any of us in a position to influence the outcome.

Solvency II

At the other end of the spectrum EU progress on Solvency II for the Insurance industry is a very different story. The Directive was originally agreed in 2009. Supervisors and industry were working towards an expected implementation date of January 2014. However, the Lisbon Treaty and the establishment of the European System of Financial Supervision necessitated certain amendments to Solvency II which were to be delivered via Omnibus II. This opened the door to other technical amendments and agreement is stalled on measures to mitigate excessive market volatility and to support products offering Long Term Guarantees (LTG). An Impact Assessment on the latter must now be completed before Omnibus II negotiations can be concluded. It is hoped this can be done in the autumn but that pushes out implementation - the current expectation is January 2016. The protracted process of Solvency II negotiations and implementation has understandably led to frustrations for supervisory authorities and industry alike. Both have put considerable time, effort and resources, not least of them financial into preparing for implementation.

Let me be clear, Solvency II is an important initiative and one that the Central Bank supports. It may not be perfect and for sure, comes with certain risk for a regulator but simply put it is a good deal better than the now very outdated Solvency I regime. Why? Because it is designed to give us a risk based approach to supervision, better governance and management of risk and improved market disclosure. However the treatment of long term guarantees has become an important and contentious road block. Somewhat frustratingly, one might reasonably have expected it to surface earlier in the negotiation process. While the LTG assessment is undoubtedly part of the solution, as is so often the case in Europe, there are strongly held divergent views which will require political compromise. The repeated delays and uncertainty risk killing momentum towards a common EU framework and the implementation of divergent national approaches to aspects of insurance supervision. Fortunately, the European Insurance and Occupational Pensions Authority (EIOPA) has moved to head off that risk - there was a shared view among members that it would be counter-productive for individual national authorities to fill the gap left by the failure to implement Solvency II. Instead EIOPA aims to continue preparations for Solvency II by introducing preparatory guidelines on systems of governance, forward looking risk assessment, pre-application for internal models and reporting to supervisors. Despite the LTG assessment much of Solvency II is clear and these guidelines will provide a good foundation for the formal implementation of Solvency II in due course and reduce the risks to the single market. In the absence of Solvency II legislation on which to “hang” these guidelines, supervisory authorities will introduce them using national supervisory powers.

At the Central Bank we plan to introduce these new EIOPA guidelines in 2014. Given our existing Corporate Governance Code and our Fitness and Probity Regime - in terms of the system of governance provisions of the interim guidelines the Irish insurance industry is already there in some respects. The reporting guideline provides for a one-year period of parallel reporting on Pillar 3 and other reporting obligations are phased in during this transitionary phase. These strike a reasonable balance between ensuring that firms are ready and able to report under Solvency II while not requiring significant dual reporting systems. Overall we see the EIOPA guidelines as a pragmatic and useful transitional step towards full implementation of Solvency II and, together with other EU authorities; we will be pragmatic in terms of our expectations of insurance undertakings during this phase.

So endeth a brief lesson on the complexities of EU financial regulation - what has gone right and what has gone wrong with two key pieces of EU legislation. Where does that leave us?

In the case of both SSM and Solvency II, we have found European solutions to European problems, so to speak. At the Central Bank we recognise the need for compromise and the need to balance competing interests in negotiating agreement on EU financial services legislation. We are active participants in the European Supervisory Authorities and support the development of consistent, prudent, high quality supervisory standards and practices. Ireland and the Irish financial services industry has benefited significantly from the single market and the industry’s ability to operate across national borders within the EU. Restoring Ireland’s credibility as a strong active regulator, both locally with the undertakings it regulates and in its participation in the European agenda, is a key part of the reform agenda nationally and is, in my view, critical to the financial services industry’s continued success here.

To maintain a strong active single market it is necessary, indeed inevitable, that regulation and regulatory structures change in response to market developments and innovations - increasingly Europe is driving that change. Regulations, regulators and the regulatory burden have all changed in recent years. There has been much talk about reform, the efficacy of the changes in preventing future problems and the role of regulation in addressing a problem once it has already developed. Academia has much to contribute in the space of challenge and constructive thinking and will hopefully (like Regulation) acquit itself better in the next group-think situation than in the last. In my opinion though and having worked in both, changes to the rules are all very well but real lasting change and reform will come only with a change in mind-set in both Public and Private Sector. That is when concepts like value-for-money, efficiency, performance management are as familiar a part of the everyday lexicon of a public sector regulator as ethics, the public good and doing the right thing by the customer are in the culture of the private sector firms that it regulates. And indeed when a top job and everything that comes with it also comes with a strong streak of individual accountability. And when challenge and diversity and corporate culture are highly valued and rewarded by senior management and the boards of our banks, our insurance companies and our credit unions (and indeed public sector organisations like ours). Banking Union and Solvency II will bring another chance at getting the framework right. It will be difficult and it will be time consuming. But in the end, people are people and how we operate within that framework: changing our ways and our minds will probably be far more important, more difficult again, far more subtle and potentially much more far-reaching in its consequence. Given all that has happened to us, and given its enormous, crippling cost and the resultant hardship caused to ordinary citizens, I believe, it is still the reform most worth pursuing, for Ireland, for Europe and for all its people.